The Blackstone alternative

Famed for its deal-making prowess -- and the bulging Rolodexes of its co-founders, Pete Peterson and Steve Schwarzman -- Blackstone has quietly built one of the biggest funds of hedge funds in the world. Talk about convergence!

In November, Blackstone Group co-founders Peter Peterson and Stephen Schwarzman threw a black-tie party at Cipriani Wall Street to celebrate the 20th anniversary of their firm. Despite the driving rain and dreadful traffic that evening, some 900 of their closest friends found their way to the downtown Manhattan landmark building, once home to the New York Stock Exchange. There they heard how the two men turned $400,000 of their own capital into a multibillion-dollar global financial services empire spanning private equity, real estate, restructuring and corporate advisory work.

Peterson and Schwarzman joked about the many difficulties they had encountered raising money for their first private equity fund. They told how one potential investor in Japan, after learning that Blackstone would be investing in the U.S., Europe and Asia, asked, “So I am going to lose money on all three continents?” To top things off, the Blackstone co-founders serenaded the crowd with their own version of Bob Hope’s signature song, “Thanks for the Memories,” complete with new lyrics that reflected humorous moments in the firm’s history.

Peterson and Schwarzman had good reason to croon. Since they turned their backs on Wall Street 20 years ago, after Peterson, who will turn 80 in June, lost a power struggle for control of Lehman Brothers, the pair has built what is today the biggest independent alternative-investment firm in the world. New Yorkbased Blackstone has raised more than $50 billion in alternative assets, a whopping $26 billion of which is in leveraged buyout funds. The firm’s new, $13.5 billion LBO fund is the biggest in history. Blackstone’s current portfolio contains about 40 companies, including Dallas-based chemicals maker Celanese Corp. and theme park operator Universal Orlando Resort, with combined total 2005 revenues of about $55 billion and more than 300,000 employees.

Blackstone’s first three private equity funds have average annualized returns of about 30 percent net of fees. Its 2002 fund, the $6.5 billion Blackstone Capital Partners IV, is on pace to do even better. That fund already has a total return of 73 percent, and like most LBO funds, the bulk of its gains should come later as more investments are sold or taken public.

And though Blackstone is best known for its private equity prowess, the firm has quietly built a powerful fund-of-hedge-fund operation, Blackstone Alternative Asset Management. Founded in 1990 with $100 million as a conduit for investing the partners’ own money, BAAM now manages $11.3 billion in funds of hedge funds for the firm and for institutions like the Missouri State Employees’ Retirement System, or MoSERS. Most of the growth has happened since 2000, when Schwarzman asked investment banker J. Tomilson Hill, who had been in charge of Blackstone’s mergers and acquisitions advisory group, if he was interested in running BAAM.

“We were looking for someone with good investment skills who could grow the business while keeping the firm out of trouble,” says Schwarzman, 59. “Tom is a wonderful partner. He said, ‘If that’s what the firm needs, okay.’”

Hill, who was recruited to Wall Street out of Harvard Business School in 1973 by legendary deal maker Joseph Perella to help build the M&A business at First Boston Corp., might seem an odd choice to head up BAAM. “You never would have expected Tom to be running a fund of funds,” says Marc Lasry, founder and managing partner of New Yorkbased hedge fund firm Avenue Capital Group, which specializes in investing in distressed debt. “In retrospect, he has been the perfect guy for the job.”

Hill’s investment banking background has turned out to be one of BAAM’s strengths, especially when it comes to picking managers. “Tom has bought and sold businesses on the investment banking side,” says Lasry, whose firm manages about $9 billion, including money from BAAM. “He’s one of those guys who is hard to bullshit. He wants to understand what you’re doing with your business.”

Hill’s financial experience has framed the way BAAM approaches its own business. As a former investment banker, Hill -- who is a vice chairman of Blackstone as well as president and CEO of BAAM -- views the world in terms of how to solve problems for clients, whether they be companies looking to grow through acquisitions, as in his former life, or pension plans trying to figure out ways to meet their funding obligations.

“We’re in the business of creating solutions,” says Hill, 57, whose slicked-back hair, pin-striped suits and French cuffs create more than a passing resemblance to Michael Douglas in the 1987 movie Wall Street. “Institutions would come to us, and we would work up solutions to meet their needs and then market them as funds.” Blackstone offers more than a dozen different funds of hedge funds, most of which were created for a single client and then opened up to other investors.

As assets have grown, so too has BAAM’s place within Blackstone. When Hill took over the group, BAAM was still mostly a vehicle for investing the partners’ money. Today it is an important revenue source for the firm. Blackstone could earn more than $125 million in management and performance fees this year on the $10 billion of its $11.3 billion in assets that comes from investors like MoSERS. In addition, Blackstone and its partners could make $150 million on the $1.3 billion of their own money invested in BAAM funds if returns match those of 2005.

“Although private equity is still the revenue engine for the firm, we’re now on par with some of Blackstone’s other businesses,” says Stephen Sullens, 39, who left Citigroup’s fund-of-fund business to join BAAM in April 2001. Sullens heads portfolio management and manager research at BAAM and became a Blackstone partner at the end of 2005.

Despite its success, Blackstone can’t escape the fundamental challenge facing the entire fund-of-fund business: the fees. As pension funds and other institutions grow increasingly comfortable with hedge funds, many could start investing directly to avoid paying the extra layer of fees that funds of hedge funds charge. BAAM, whose business has already morphed once, is changing its strategy to meet that challenge. Hill wants BAAM to be a more active investment adviser and has introduced several opportunistic and theme-oriented funds that he and his team can use in conjunction with BAAM’s existing products to create customized vehicles for clients. Meanwhile, Blackstone isn’t taking any chances: Last year the firm launched its first hedge fund, a $600 million fund that invests in distressed debt.

Donald Putnam, founder and managing partner of Boston-based merchant bank Grail Partners, expects Blackstone to be among the survivors in the fund-of-hedge-fund shakeout he predicted in his November 2005 paper, “Adapt or Die Trying,” as pension funds and other institutions start going direct. “Blackstone is the exception that proves the rule,” says Putnam. “When Blackstone encounters a market challenge, the firm moves forward to meet it rather than just bury its head in the sand the way many large companies do.”

SINCE ITS EARLY DAYS, BAAM HAS PROVIDED clients with access to some of the hedge fund world’s most respected managers, starting with New Yorkbased Tiger Management Corp. legend Julian Robertson Jr. and Caxton Associates’ Bruce Kovner. Today, BAAM invests with about 150 hedge fund managers, including Tiger cubs Stephen Mandel Jr. of Lone Pine Capital and Lee Ainslie III of Maverick Capital, as well as former Goldman, Sachs & Co. merger arbitrageurs Richard Perry of Perry Capital and Daniel Och of Och-Ziff Capital Management Group.

Capital preservation is a core principle at BAAM, which is known among managers and investors for the thoroughness of its due diligence. “It’s absolutely no coincidence that Blackstone has avoided all the major blowups of the past decade, including Long-Term Capital Management,” says Matt Long, chief investment officer of Lord Baltimore Capital Corp., a Maryland-based family office that has $275 million in hedge funds and has been a BAAM investor since 1999.

Avoiding disasters is of paramount importance to Schwarzman: A big chunk of BAAM’s assets are his and his partners’. “We’ve got more than a billion dollars of our own money in our products,” he says. “Our desire to get a phone call saying that we’ve lost money is exceptionally low.”

Blackstone has long been a safe choice for pension funds and other more-risk-averse institutions looking to dip their toes in the hedge fund waters. Almost half of BAAM’s assets come from ERISA or state pension plans. They have been willing to pay Blackstone’s 1 percent-plus management and performance fee, which is layered on top of the fees of the underlying hedge funds. Rick Dahl, CIO of Jefferson City, Missouribased MoSERS, says Blackstone’s fees are generally in line with what other large fund-of-fund firms charge.

Unlike most fund-of-hedge-fund firms, which have a reputation for being hot money, Blackstone is perceived favorably by hedge fund managers because of its stable of more than 200 institutional investors. “Blackstone is not worried about its clients leaving tomorrow if the firm has a bad month,” says Avenue Capital’s Lasry. “Even though they are a fund of funds, I view them as an institutional investor. If they invest with you, they are there for the long term.”

Paul Singer agrees. “These guys do it right,” says the founder and general partner of New Yorkbased Elliott Associates, a $5.7 billion hedge fund firm that invests in distressed securities and special situations. “It’s a real relationship, not just a passive infusion of money.”

Still, Blackstone has yet to achieve the dominance in hedge funds that it has enjoyed on the private equity side of the firm. In Institutional Investor’s Fund of Funds 50, our annual ranking of the world’s biggest multimanager hedge fund firms by assets, Blackstone was No. 15 in 2005, dropping two places from the previous year. Not only were Blackstone’s assets dwarfed by those of Zurich-based UBS and Man Investments in London, which had $45.0 billion and $35.6 billion, respectively, they also trailed the assets of U.S. rivals Quellos Capital Management, Ivy Asset Management Corp. and Grosvenor Capital Management by more than $5 billion each.

Hill says he deliberately slowed BAAM’s asset growth in 2004 after the torrid pace of the previous two years. BAAM’s assets had nearly tripled between January 2002 and January 2004, jumping from $2.6 billion to $7.6 billion, and Hill knew he needed to build out his team to find new hedge fund capacity or risk diluting Blackstone’s top-quartile performance. “Many of our investors are also limited partners in other Blackstone products,” says Hill. “They’ll be grumpy if we don’t do well.”

In 2004, Hill hired Bruce Amlicke from UBS to be chief investment officer of BAAM, responsible for overseeing day-to-day manager selection and portfolio construction. As the former CIO of UBS’s global fund-of-hedge-fund business, Amlicke has experience putting money to work quickly. UBS’s assets grew from $600 million to more than $15 billion during his six years there. “It was a big deal for Blackstone to hire Bruce,” says Steven Tananbaum, co-founder and CEO of New Yorkbased GoldenTree Asset Management, which oversees about $7 billion in credit-related products, more than half of which are hedge funds. “Particularly for a firm of its size, Blackstone has been able to be pretty agile and very much forward-looking.”

Amlicke has streamlined the investment process, dividing the portfolio management and manager research team into three strategy clusters -- equities, event-driven and arbitrage, and fixed-income. His arrival enabled Hill to expand the role of former CIO Halbert Lindquist, now 59, moving him into the newly created position of chief investment strategist. Together Amlicke and Lindquist have pushed BAAM’s investment team to be more opportunistic. (For more on the investment process, see box.)

“It’s not just about being with the right managers,” says Amlicke, 42, who began his career trading currency options for Chicago-based O’Connor & Associates, which later merged into UBS. “It’s also about being in the right space.”

In January 2005, BAAM launched several new, more-concentrated funds of hedge funds. Market Opportunities, an opportunistic strategy that invests in managers with longer lockups, returned 14.9 percent after fees in its first full year. BAAM also introduced sector-focused funds last year, including Emerging Markets and Commodities, which were up 11.8 and 12.6 percent net of fees, respectively, for the full year. Even BAAM’s 11-year-old, conservatively managed Park Avenue strategy performed well in 2005, up 11.4 percent. Chicago-based Hedge Fund Research’s HFRI fund-of-funds composite index was up 7.5 percent in 2005.

At a time when many fund-of-hedge-fund firms are starting to see investor withdrawals, money is flowing freely into BAAM. Its assets grew by more than $1 billion from pension funds and other institutions during the last six months of 2005 -- a period during which the fund-of-hedge-fund industry experienced a net outflow of $3.3 billion, according to HFR.

BAAM’s recent success comes as the distinction between hedge funds and private equity is blurring. “Everything is converging right in front of our eyes,” says CIO Amlicke. “Hedge funds and private equity, hedge funds and mutual funds, hedge funds and funds of funds, funds of funds and consultants -- it’s a free-for-all landgrab for alpha.”

LIKE MANY PARTNERS AT BLACKSTONE, TOM HILL and Steve Schwarzman have Ivy League pedigrees. Hill grew up in New York City, where his father was an attorney at Sullivan & Cromwell before becoming a venture capitalist. The younger Hill graduated from Milton Academy, a private preparatory school outside Boston, in 1966 and then went to Harvard College, where he studied history, literature and Japanese. Schwarzman, whose father owned a draperies-and-linens store, attended public school in a suburb of Philadelphia before entering Yale University in 1965.

Hill and Schwarzman both attended Harvard Business School in the early 1970s, but that’s not where they met, says Schwarzman, who was a year ahead of Hill. They met at an old military base in Boston, where they served together in an Army Reserves intelligence unit during business school. Hill, who had drawn a very unlucky “13" in the draft lottery, surely would have gone to Vietnam had he not joined the Army Reserves following graduation from Harvard College.

After business school, Schwarzman and Hill each headed to Wall Street. By 1978 merger specialist Schwarzman was a partner at Lehman Brothers and a key lieutenant to CEO Pete Peterson. In 1982, Peterson recruited Hill, who was then running the M&A department at Smith Barney, to join Lehman as a partner in its powerful mergers group.

Fifteen months later, Peterson was gone, forced out by Lehman co-CEO Lewis Glucksman in a palace coup that left the firm splintered and led to its eventual sale to American Express Co. Schwarzman departed in mid-1985 to rejoin his mentor and form Blackstone. Hill, who advised Time on its 1990 purchase of Warner Communications, stayed on, eventually rising to co-CEO of Lehman before being forced out himself in 1993 after butting heads with AmEx CEO Harvey Golub over compensation issues.

Business at Blackstone, meanwhile, was booming. The firm had advised companies on more than $40 billion in mergers by 1993; that year it raised a $1.3 billion buyout fund. Hill joined Blackstone in November 1993 as a partner to help with its M&A advisory group, serve on its investment committee and develop new financial services affiliates like BAAM.

BAAM was born from the 1990 purchase of a $100 million minority stake in Blackstone by Japan’s Nikko Securities Co. ThenBlackstone partner David Batten suggested that rather than put the money in Treasuries, the firm invest it with hedge fund managers he knew, including Tiger’s Robertson, Caxton’s Kovner and Kingdon Capital Management’s Mark Kingdon. Schwarzman gave Batten the green light, with one instruction: Don’t lose the partners’ capital.

By 1993 the Partners strategy had started taking outside money from a few of Blackstone’s LBO investors. The fund had an eclectic mix of long-short equity, event-driven, relative-value and arbitrage managers. In January 1995, at the request of one of its institutional investors, BAAM split off the equity managers into a new strategy, Park Avenue, named for the street where Blackstone is headquartered. Both Partners and Park were designed from the beginning to be highly defensive funds of hedge funds that deliver consistently positive returns with little correlation to the movements of traditional stock and bond markets.

In October 1996, Hill hired Carrie McCabe as chief operating officer of BAAM, which by then had $500 million in assets, most of it still Blackstone’s own. McCabe, who began her career on the mortgage-backed-securities desk at Bear, Stearns & Co., was developing hedge fund products for Mariner Investment Group in New York when Hill hired her. He charged her with growing BAAM’s assets as well as expanding its offerings.

The following summer, McCabe reached out to Lindquist, who had recently retired from Bear Stearns, where he had headed global risk management and proprietary trading. She called him in Sun Valley, Idaho, while he was on vacation with his family and asked if he would come in and evaluate BAAM’s portfolios. For the first six months, Lindquist worked behind the scenes as a consultant, suggesting changes to the portfolios. In January 1998 he was appointed CIO, and McCabe became CEO.

When Lindquist arrived, BAAM had about 35 managers for its Partners and Park Avenue strategies. What the firm did not have was a centralized way to monitor and analyze them, which it would need to significantly grow the business. Lindquist hired a computer programmer and over the next 18 months developed Hedgehog. The software platform enables Blackstone to aggregate the performance and risk data for all of its hedge funds and portfolios, forming a giant database in which the information can be sliced and diced in dozens of different ways. Blackstone also uses Hedgehog to organize the information generated by the countless manager visits, portfolio meetings and conference calls that take place during its investment process, as well as to provide a repository for client information and reporting.

Lindquist, an Arizona native who got his start on Wall Street in the 1970s trading government bonds at Salomon Brothers, brought something else to BAAM. “We found that after Hal joined, our relationships with managers changed,” says Schwarzman. “When markets got difficult, hedge fund guys would call Hal to find out what he thought they should do with their portfolios.” Managers respected Lindquist’s advice not just because he was an ex-trader but because when he was at Bear, he had the power to pull the plug on any of the firm’s proprietary traders if he thought their positions had gotten too risky.

McCabe resigned from Blackstone in February 2000 to start her own financial advisory firm. During her time at BAAM, the group’s assets more than doubled, to $1.2 billion, although almost half of that was Blackstone’s own money. McCabe, who declined to comment about her departure, is now CEO of FRM Research, a $13 billion, London-based fund-of-hedge-fund firm. She manages FRM’s U.S. business.

Hill took over as CEO of BAAM after McCabe left. At the time, the group had eight professionals. Today it has 100, split among investments, operations and client relations, and assets have grown proportionately. Part of that growth is simply a reflection of the times. Like many firms, BAAM benefited from the 2000'02 bear market, as investors sought refuge in hedge funds to escape the carnage. Assets in funds of hedge funds nearly tripled between the end of 2001 and the end of 2003, jumping from $103 billion to $293 billion, according to research firm HFR.

One of the key reasons for BAAM’s growth was Hill’s decision in December 2000 to throw his firm’s hat into the ring for an advisory assignment with the California Public Employees’ Retirement System, which was looking for a strategic partner to help it invest its first $1 billion in hedge funds. BAAM was among 35 firms asked by CalPERS, the U.S.'s largest public pension plan, to submit a request for proposal. “CalPERS was looking for a group to educate us, provide us access to top-tier hedge funds and keep us from making any rookie mistakes that would jeopardize the program,” says Kurt Silberstein, Sacramento-based portfolio manager for Absolute Return Strategies, CalPERS’s hedge fund program.

As CalPERS whittled down the list, Hill and his team made it through each stage of the selection process, despite their refusal to cut their fees. In April 2001, CalPERS invited three finalists -- BAAM, Goldman Sachs Hedge Fund Strategies and J.P. Morgan Alternative Asset Management -- to come to Sacramento for one last interview. It was not a coincidence that all three were affiliated with respected financial institutions; whichever name CalPERS chose would carry very little reputational risk. A month later, CalPERS announced it had picked BAAM, in part because CalPERS had been an investor in Blackstone’s private equity funds and was very comfortable with the firm.

Winning the CalPERS mandate was a huge victory for BAAM. “CalPERS was the Holy Grail,” says Hill. “They interviewed everybody. Getting their imprimatur was invaluable to our business.”

BAAM’s job was to source hedge funds for CalPERS and help with due diligence, research and performance reporting, as well as monitor risk management of the portfolio -- all things that it did in the regular course of its fund-of-fund business. But in this case, BAAM was only an adviser. CalPERS would be the direct investor in the hedge funds and had final say over manager selection.

The assignment turned out to be somewhat frustrating for BAAM. Lindquist and his team -- which by then included California native Sullens and head of risk management Michael Purvis, a former mortgage securities trader at NatWest Bank in New York -- spent the first year educating CalPERS’s investment staff about hedge funds. CalPERS didn’t make its first investment until April 2002, a meager $50 million spread evenly among five different hedge fund firms.

As 2002 came to a close, Hill’s group had grown to 28 people, including Brian Gavin, Dana Auslander and Gideon Berger, who were all hired within a two-month stretch that spring. Gavin, a former partner in the hedge fund advisory group at accounting firm Arthur Andersen in New York, oversees operational due diligence, as well as business monitoring of managers with which BAAM has already invested. Auslander, a lawyer who began her career at New Yorkbased Schulte Roth & Zabel, handles the legal structuring of BAAM’s portfolios and also gets involved in manager due diligence. Berger, who has a Ph.D. in computer science from the Courant Institute of Mathematical Sciences at New York University, started in the risk group at BAAM before being promoted to head asset allocation.

CalPERS, meanwhile, had invested just $580 million of its $1 billion hedge fund allocation by the end of the second quarter of 2003. It had also decided to bring in two more firms, UBS and Pacific Alternative Asset Management Co., to help advise on its hedge fund portfolio, squeezing Blackstone’s influence, if not its fees. Later that year, when BAAM’s two-year contract came up for renewal, Hill opted out.

Although Hill learned from BAAM’s experience with CalPERS that his group doesn’t want to be in the pure advisory business, providing investment advice is integral to BAAM’s solutions-driven approach to building funds of hedge funds. Most of its products, starting with Park Avenue, were originally created to meet the needs of single institutional clients.

Two of BAAM’s biggest clients have funds that were designed specifically for them. In January 2002, BAAM started the market-neutral Madison Avenue strategy for the Pennsylvania State Employees’ Retirement System to use with its portable-alpha program. A year later, BAAM launched the slightly more volatile Hedged Equity strategy for MoSERS, which was looking to capture alpha from long-short equity managers whose returns have a low correlation to movements in the overall equity markets.

The experience of PennSERS is revealing. Like many public pension funds, the Harrisburg, Pennsylvaniabased plan was somewhat wary of funds of hedge funds because of the double set of fees. In 1998, after CIO Peter Gilbert got approval from the PennSERS board to invest in hedge funds, he initially went direct, hiring four long-short, market-neutral managers. Gilbert says the returns in 1999 and 2000 were disappointing. “We learned that if we were going to do this type of transportable alpha, we had to be very diversified, and that led us to look at funds of funds,” he explains.

Unlike CalPERS, PennSERS didn’t go through a formal RFP process. Gilbert and his team researched both funds of hedge funds and multistrategy single-manager funds and ultimately chose Blackstone because it had robust risk controls, an excellent track record and, importantly, experience dealing with institutions like theirs. In 2001, when PennSERS was doing its research, most funds of hedge funds still catered to wealthy investors.

It also helped that PennSERS was a longtime investor in Blackstone’s private equity and real estate funds. Today, Gilbert has invested $1.7 billion of PennSERS’ $28.4 billion plan in BAAM products. As the initial investor in Madison Avenue, PennSERS was able to negotiate lower fees from BAAM.

MoSERS CIO Dahl received approval from his board in 2002 to invest in hedge funds. “We considered going direct with the help of a consultant,” he says. “However, given the internal resources we had available at the time, both human and technological, it seemed to us that the fund-of-fund route was the better way to go.”

Like Gilbert, Dahl thinks of hedge funds as a way to generate alpha, not as an asset class. Dahl, however, was looking for a little more kick from his hedge funds than that offered by the largely market-neutral Madison Avenue, which has a beta of less than 0.1 (meaning it has less than 10 percent of the volatility of the broad equity market). BAAM designed Hedged Equity strategy to have a beta of 0.4. Dahl initially invested $250 million in Hedged Equity and a further $225 million in Madison Avenue. Today, Dahl has $735 million of MoSERS’ $7 billion in total assets with BAAM, including $460 million in Hedged Equity.

AS PART OF BLACKSTONE GROUP, Tom Hill and his team at BAAM have access to what is known within the firm as the library. The Blackstone library isn’t an actual place, although the plush carpets, heavy draperies and even heavier furniture at the firm’s Park Avenue offices would make many old-school bibliophiles feel right at home. The library is the cumulative knowledge that Blackstone has amassed across its myriad businesses as it analyzes hundreds of deals a year in dozens of industries on multiple continents. For every private equity or real estate deal Blackstone does, the firm may study 20, hiring outside consultants and former executives to supplement the mountains of research generated by its own analysts. “We know an enormous amount about a lot of different businesses,” says Schwarzman. “It’s a continual education machine here.”

Hill uses the Blackstone library to enhance BAAM’s relationships with its managers, such as Elliott Associates’ Singer. “BAAM has been very forthcoming about having other areas of the firm open to me and to my analysts to talk through industries in which we’re interested,” says Singer, whose investment from BAAM dates back more than a decade. As a longtime investor in distressed debt and special situations, Singer likes talking to Blackstone’s restructuring group, led by Arthur Newman, who ran Chemical Bank’s restructuring business before joining Blackstone in 1991. “They have powerful insights into the world, and that’s really valuable to me,” says Singer.

Maverick manager Ainslie also views BAAM as one of his strategic investors. Having access to Blackstone’s analysts is especially valuable to firms like Maverick that organize their investment teams by industry sectors. “As Blackstone is one of the leading and more thoughtful private equity investors, the ability to have a dialogue with the firm’s senior people has been very helpful,” says Ainslie.

For example, an analyst at Maverick, which is based in Dallas but runs the bulk of its investment operation out of New York, can turn to Blackstone to ask if a company the firm is interested in shorting is a good LBO candidate. If that is the case, Maverick may decide not to short the company because the mere possibility that a private equity buyer might come along could keep its shares from dropping even if its underlying business is troubled.

When it comes to Blackstone’s own business, Schwarzman says his firm needs to do a better job of taking advantage of the intellectual capital being generated by its various pieces. He is doing his part. Every two to three weeks, Schwarzman gets together with Hill, Amlicke and Lindquist to discuss what’s happening at BAAM and to share what he is seeing in Blackstone’s other operations.

In 2004 the four men talked a lot about the challenges facing the hedge fund industry. Although asset flows into funds of hedge funds had begun to slow from the frenetic pace of the previous two years, most of BAAM’s competitors were continuing to follow the same simple formula that had led to their success: Invest as much money as possible with the best established managers willing to take it and simultaneously try to identify the next generation of stars to create capacity for the inevitable flood of new capital.

“Everybody was playing in the same game, with the same positions and asset allocation, hoping not to step on a land mine,” says Amlicke. “That passive approach works only when there’s a wall of money coming at you.”

During a series of meetings that fall -- many of which were held around an antique hardwood table in the conference room adjacent to Schwarzman’s 31st-floor Park Avenue office -- the BAAM brain trust agreed that their firm’s business model had to change. They saw that returns from convertible arbitrage and other low-volatility investment strategies then popular among funds of funds had fallen considerably and would likely continue to disappoint investors as more money poured into them.

Hill and the BAAM team reasoned that under the traditional fund-of-hedge-fund model, the industry’s’ asset growth would itself hit a wall as investors eventually balked at paying a second set of fees for mediocre returns. They came up with a plan that would not only prevent that from happening to BAAM but would also position the firm to capitalize on others’ misfortunes.

“The future of our business is to be further out on the active management side,” says Hill, who thinks of BAAM as an investment adviser, not as a fund of hedge funds. “We’re hoping to win a lot of assets from fund-of-fund firms that offer the one-size-fits-all approach.”

Part of the problem with the traditional model is that fund-of-hedge-fund firms may end up diversifying too much as they keep adding hedge funds to their portfolios to be able to take in more assets. “The notion that you need 40 to 50 hedge funds to have a diversified fund of funds is insane,” says Hill. “You need to be more concentrated.”

In February 2005, BAAM launched the Market Opportunities strategy, which at year-end had investments with 15 managers. The fund has a three-year lockup that mirrors the lockups of many of its underlying managers.

Five months later, BAAM introduced the Strategic Equity strategy, which also has a three-year lockup. The fund is the brainchild of Amlicke, who was looking for a way to create capacity with some of BAAM’s top hedge fund managers that had stopped taking new money. He came up with the idea after talking to one such manager, who was very bullish on Apple Computer but had run up against position limits in his fund’s offering documents that forced him to reduce his investment as the company’s share price soared. Amlicke suggested that BAAM build a product around a select group of its managers that would encourage them to take highly concentrated bets on their best ideas.

“A lot of hedge funds today are running their business to satisfy their most risk-averse investors,” explains Amlicke. “This fund takes the handcuffs off them and lets them operate the way they did when they started.”

Strategic Equity has money with just five managers -- two U.S. long-short, an Asian long-short, a European long-short and one activist -- all of whom have agreed to give BAAM up to $250 million in capacity in return for a three-year lockup and anonymity. BAAM has asked the managers to invest in no more than a dozen positions. By design, the fund will be more volatile than BAAM’s other products. “It still has downside protection, but there’s much more upside,” says Schwarzman. Strategic Equity, which had $450 million in assets at year-end, was up almost 8 percent net of fees during its first six months.

Asset allocation is central to BAAM’s new strategy. Although all fund-of-hedge-fund firms devote at least some time to figuring out how to divide their assets among the various hedge fund strategies, few if any have the resources of the Blackstone library to help shape their allocation decisions. BAAM’s senior management team regularly talks with Schwarzman, Peterson and Blackstone president Hamilton (Tony) James about what is happening in other parts of the firm. In private equity, for example, Blackstone’s holdings include U.S. theme park Legoland, safety-parts maker TRW Automotive Holdings Corp., publisher Houghton-Mifflin Co. and U.K. pub operator Spirit Group, giving the firm a unique window into the global economy.

“We’re seeing on a weekly basis what’s happening to energy prices, the cost of steel, consumer spending and other economic factors,” says James, 55, who joined Blackstone from thenCredit Suisse First Boston in 2002. “That advance notice can inform BAAM and help it decide whether to be more aggressive or defensive.”

Several members of Hill’s senior management team get involved in the asset allocation decision making, including Amlicke, Berger, Lindquist, Purvis and Sullens. They meet early each month to go over what they are seeing in the different hedge fund strategies. “All of this is about trying to figure out what the newspaper headlines will be six months from now,” says Lindquist. “We don’t get paid for having yesterday’s newspaper.”

As chief investment strategist, Lindquist plays an important role in the asset allocation process -- both for BAAM’s own portfolios and for its investors’. “My main function is picking the right place to play in the sandbox,” says Lindquist, who works closely with asset allocation head Berger to create customized funds for the firm’s bigger clients. These funds, which are legally structured as special-purpose vehicles, enable investors to move their assets more easily and quickly among the firm’s various products. In addition to investing in BAAM’s diversified strategies like Park Avenue and Partners, the SPVs can allocate assets to what BAAM calls pods -- sector-focused funds such as Emerging Markets and Commodities.

In January, BAAM set up an SPV for Dahl of MoSERS. The Missouri pension plan funded the SPV with $275 million that it had invested in the Madison Avenue strategy. “The expectation is that the SPV will enable us to get slightly higher alpha with about the same level of overall volatility,” says Dahl, who has moved about one third of MoSERS’ assets out of Madison Avenue into five other BAAM funds, based on the advice of Lindquist and Berger. Dahl, however, says MoSERS has no intention of moving the $460 million it has invested in the Hedged Equity strategy because as the initial investor in that fund, the plan gets a break on fees.

The pods enable BAAM to be more opportunistic. Last year the flagship Partners Fund got a boost by investing a small percentage of its assets in the Emerging Markets pod, which like the Commodities pod is available only to SPVs and BAAM’s funds of hedge funds. The Emerging Markets pod was up 11.8 percent net of fees in 2005. In January, BAAM introduced two new pods that are open to external investment: Pacific Opportunities, an Asia fund, and Corporate Opportunities, which invests in activist managers. To date, BAAM has created seven SPVs, representing approximately $2.8 billion of the firm’s $11 billion-plus in assets, and has two more on tap for this spring that will add a further $400 million in assets.

The SPVs and pods are important pieces of Hill’s plan to transform BAAM from a fund-of-hedge-fund firm into an investment adviser that offers hedge funds as part of the service it provides for its institutional partners. If successful, Hill says, the transformation should help BAAM reach $15 billion in assets within the next two years, even as some pension funds and other large investors bypass funds of funds because of the extra layer of fees.

For all his cool confidence, Hill is helping Blackstone hedge its bets. In late 2004 he recruited distressed-debt specialist John Dionne from Bennett Restructuring Fund, a $1 billion New Yorkbased hedge fund. Dionne, who had been the No. 2 at Bennett, was looking to start his own fund, and Hill suggested that he do it as a Blackstone partner. Dionne, 42, took him up on the offer, influenced by then-tough conditions in the distressed-debt market as well as by the depth and breadth of the Blackstone library, especially valuable for the industries in which he invests.

Dionne joined Blackstone in January 2005. Six months later the firm launched its Distressed Securities Fund, which now has $600 million, including $100 million of Schwarzman’s and the other partners’ money. The fund, managed by Dionne, is Blackstone’s first hedge fund and has about 60 investors. BAAM is not one of them. To avoid obvious conflicts of interest, Hill’s group is prohibited from investing in Blackstone’s own funds. That’s perfectly fine with Hill, who is readying Blackstone to roll out its second hedge fund, a long-short equity fund with assets of as much as $1 billion.

“Many institutions are going to want to invest directly in hedge funds,” says Hill. “Our model is not stuck in providing funds of funds. We can create more in-house strategies the way we’ve done with John.”

How BAAM turns prospects into profits

Mondays are mandatory. That’s the unwritten rule at Blackstone Alternative Asset Management’s Park Avenue headquarters.

Starting promptly at 9:30 every Monday morning, BAAM’s equity strategy team meets with CIO Bruce Amlicke and Stephen Sullens, who heads portfolio management and manager research, in a video conference room at Blackstone to set that week’s agenda. For 60 minutes the cluster team, as the firm calls it, discusses new manager leads, ongoing due diligence of hedge fund prospects and the monitoring of funds with which Blackstone already has money. At 10:30 a.m. the arbitrage and event-driven strategy cluster goes through the same drill, followed at 11:30 a.m. by the fixed-income and relative-value team. At 1:00 p.m., Amlicke and Sullens bring together the three groups in a “prospect” meeting that also includes BAAM’s operational due diligence, risk management and legal teams.

“Our whole travel schedule is worked around the fact that it’s pretty important to be here on Mondays,” says Sullens.

The cluster groups and meetings are the handiwork of Amlicke. Since BAAM CEO J. Tomilson Hill hired him in 2004, Amlicke has formalized the investment process at the same time that he has tried to maintain its flexibility and creativity. One way he does that is by setting up ad hoc SWAT teams to focus on new investment opportunities, pulling members from the various clusters to work together on a project-by-project basis. In the past year he has set up SWAT teams to look at emerging markets and reinsurance.

BAAM meets with more than 1,000 hedge fund managers a year. Of these, the firm actively monitors about 500, using its Hedgehog software platform to collect and analyze performance data. Only after Amlicke, Sullens and the members of the appropriate cluster are confident that a manager can deliver alpha does that manager become a prospect, at which point BAAM brings in its operational due diligence team. The group, which is led by Brian Gavin -- a trained accountant whose father is a retired New York City policeman -- does extensive background checks on every hedge fund manager that BAAM considers.

Gavin’s team focuses on a hedge fund’s business viability, as most blowups are caused not by fraud but by operational problems such as the lack of independent price verification of securities. Gavin’s group reviews operational procedures, including auditing, compliance, trade reconciliation and disaster recovery, and talks to the fund’s outside administrator, prime broker and accountant.

The BAAM investment team is very picky. The firm invests with 35 to 50 new managers each year. Annual manager turnover, historically about 10 percent at BAAM, has gone up since Amlicke took over the operation two years ago. It’s now 15 to 20 percent.

Much of the increased turnover is a function of Amlicke’s efforts to make BAAM more opportunistic, using his team’s top-down asset-allocation views. In 2005, BAAM shifted almost $900 million of its assets out of convertible and fixed-income arbitrage managers, commodity trading advisers and long-biased credit managers. At the same time, it ramped up its investment in activist managers, Asian hedge funds, energy traders, emerging-markets managers and funds that do direct lending, adding about $2 billion to those strategies. -- M.P.